Economic analysis does not support many of reforms that are being implemented.
Life after Kyoto reviews ways to efficiently manage global public goods with interest in global warming. The goal of global warming policy is to maximize environmental improvement per dollar. The conclusion is that price-type approaches (i.e. taxes) are more efficient than quantity-oriented control mechanisms (like the quota program of the Kyoto Protocol).
Based on 1990 carbon dioxide levels, the Kyoto Protocol is an international agreement between industrialized countries that assigned each countries permit which can be bought and sold. Lasting only from 2008 to 2012 there are many shortcomings for the Protocol, including no measures for the addition of new countries. The United States withdrew in 2001, and author Nordhaus believes that Protocol is “between troubled and terminal.” Nordhaus argues global warming policy must be efficient and the cost of reducing the warming should be shared equally and the Kyoto Protocol fails on both accounts. He reasons that the tradable emissions permit of the Protocol should be replaced by a tax system.
The success of global policy in dealing with global public goods has been at best mixed. Global public goods include intellectual property rights, international trade, nuclear proliferation, international environmental issues, fisheries, the AIDS epidemic, and the threat of avian flu. The mechanisms for global policy are 1) a laissez-faire approach (nothing) 2) non-binding voluntary agreements 3) specific and binding treatments and 4) agreements embedded in a broader arrangements (such as Western nations providing favorable multilateral trade negotiations in exchange for the enforcement of patents). In the case of global warming, Nordhaus states that a laissez-faire approach will not work because because there is a market failure in the form of the negative externality of pollution. The Kyoto Protocol is the first legislation to acknowledge this fact, but he feels that we can do much better. Nordhaus admits that quantity approaches are attractive to policymakers and environmentalists because they provide certainty in the form of ceilings for emissions. He believes, however, that harmonized carbon tax should be designed because it will be superior for ten reasons:
- Halting emissions at a certain level, as permits intend to do, does not accomplish the ultimate goal of lowering the temperature. Like taxes, a quantity approach also sets a price for carbon emissions because a country must determine the price for buying and selling permits. However Nordhaus believes that it is easier (and in this case more efficient) to design a tax that directly sets a price rather than set a quantity that indirectly sets a price.
- The use of a baseline emission level (1990 for the Kyoto Protocol) does not divvy the burden equally because it penalizes countries that were efficient in the baseline year and high growth countries like the USA. Furthermore, slow growth or historically bad polluters will have an advantage because they are much closer or even below their baseline year carbon usage.
- The nature of the uncertainty in climate change indicates that taxes will be more efficient. Because the benefits are the decrease in the stock of total greenhouse gases and the costs are related to the flow of emissions, the marginal costs from reductions will be highly sensitive to the reduction level while the marginal benefits of the reduction will be unrelated to the reduction’s current level. A small curvature of the benefit function compared to the curvature function is called a static Weitzman problem and economic theory supports a tax in these circumstances.
- Because the supply of permits is inelastic in a quantity-based solution and demand for these permits will be relatively inelastic in the short-term, carbon prices will be volatile and, therefore, inefficient. For example, in a similar quantity-based program for sulfur dioxide prices have ranged between $70 and $1500 in the last two years in the US.
- Taxes have a strong fiscal policy preference over free permits in part because free permits create a “double burden.” Prices are raised for the consumer and real income is reduced for the producer without anything to offset losses. With a tax, revenue is created that can be used to lessen the marginal deadweight loss. It is possible that permits could create revenue by being sold but current indications suggest that permits will be allocated at zero costs to reduce political frictions.
- Quantity-based programs are more susceptible to corruption than a tax system. Limiting emissions in a trading system creates a sellable scarcity (permits) where none previously existed. With this artificially-created wealth, corrupt leaders can sell the permits and use the money for non-environmental purposes (dubbed “the purchase of wine and guns.”) A tax cannot generate these false scarcities, monopolies, or rents. Another important point is that additional monitoring will be needed to halt this diversion of funds, and this task has proved most difficult in other global goods such as nuclear weapons.
- Another problem is the issue of monitoring. Country A can sell its permits to Country B and, if not properly monitored, continue to pollute at their original level creating a positive sum game for the two parties. However, tax evasion is a zero-sum game (the business win but the government loses) so there is less incentive for cheating. This type of corruption is not necessarily limited to developing countries. The accounting scandals of the Enrons of the United States demonstrate that no country is invulnerable.
- One objection of a tax is the development of administration to determine the practical effect of the tax. The practical effect of the tax is important because in order to foster international cooperation the relative burden to each country must be shared equally. Countries could develop loopholes for high energy industries which would prevent a country from fully internalizing the costs of their emissions. For example, a country could subsidize the coal industry to offset the reduction in production caused by the tax. However, full disclosure to an international body like the International Monetary Fund (IMF), which already reviews the overall composition of taxes with many countries, would help clarify the effect and enforcement of the tax. Calculating the effective carbon tax appears more tedious than unmanageable.
- Another issue which is similar to the baseline problem of the quantity-based approach is determining how much tax to add to the carbon taxes previously in place. Europe currently charges about $100 more per ton of carbon than the United States so an additional tax of $50 would disproportionately hurt Europe. However, unlike baseline problem of the permit system, a simple solution in the form of calculating all new taxes by setting the old taxes to 0 is available. If it is determined that Europe needs to increase taxes by $50 than the United States would increase its taxes by $150. Also, the very idea that Europe is overtaxing carbon today compared to the United States never comes up in a quantity approach.
- Neither approach solves the end goal of determining the efficient carbon concentrations and climate change because we do not know what these levels are. However, at the very least, taxes will be more efficient because the uncertainty and linear benefit schedule can be better matched with taxes the price volatility inherent in the use of permits.
The Nordhaus article was a pleasure to read and promoted a tax system well. However, his article was overly one-sided on his belief in the superiority of taxes to the permits of a quantity-based approach. Many of the problems of the Kyoto Protocol can be rectified without throwing out the entire plan. Instead of using 1990 as the baseline year for the permits where countries with rapid growth in the last 15 years are penalized, why can’t 2005 be used? The tax would only be efficient if it was adjustable and the use of annual permit contracts would achieve this goal equally well. Another problem with the Kyoto Protocol according to Nordhaus is the fact that only industrialized countries have signed on. A tax would make it even less likely for a poorer country to join because taxes will hurt their already fragile industry. Many developing nations rely primarily on the export of natural resources for their GDP and many of these processes are energy-intensive. From a global perspective, the wealth of industrialized countries is at the expense of the environment of the entire world. Giving countries permits based on their population and allowing them to sell these permits is the only fair way to distribute the burden.